China's financials need an overhaul

By Diana Farrell

Aggressive reform of China's financial system is necessary to promote sustainable growth, according to research by the McKinsey Global Institute.

McKinsey Global Institute's director says aggressive reform of the mainland's financial system is necessary to promote sustainable growth

The Chinese economy continues to defy gravity. Gross domestic product grew by 11.3% in the second quarter, its strongest clip in more than a decade.

Beijing—and much of the rest of the world—is afraid that pace is simply too fast and that the mainland runs the risk of overheating. The government has implemented various measures to rein in growth, but investment is up 30% from the second quarter a year ago as money continues to pour into everything from highways to housing estates.

One big reason China hasn't been more successful at tamping down its hypergrowth: Beijing hasn't done enough to reform its financial system. Although changes are under way, it will take years for them to make much of a difference. A comprehensive, clearly targeted, and more aggressive reform program is needed to avoid the boom-bust cycles of the past.

Problem is that current policies are undermining those efforts. In May, the People's Bank of China (PBOC) raised interest rates by 27 basis points, to 5.85%, in hopes of slowing the flood of cheap credit that has fueled growth and investment. By the end of the first quarter, total bank lending had already hit half the 2006 official target of 2.5 trillion yuan, or $312.5 billion. While the small rate hike may deter some businesses from borrowing, bank deposit rates—still firmly controlled by the PBOC—have not budged. The rise in lending rates has thus resulted in higher bank margins, perversely giving banks an incentive to lend more, not less.

Better Lending
As long as deposit rates remain capped, lending rates will remain very low by international standards. Research by the McKinsey Global Institute finds that publicly traded enterprises in China pay an average of 5.1% in interest, compared with 6.8% for listed US companies—despite the smaller size of Chinese businesses and the more volatile economic environment in which they operate. The modest rise put through in May won't make up this difference, nor will it slow investment.

To put the economy on a more sustainable path, the government should spend less energy trying to reduce lending and instead encourage banks to lend more productively. China's banks currently lend the most to large state–owned enterprises (SOEs) that, despite recent reforms, are still the least productive part of the economy. Privately owned companies in China are, on average, twice as productive as state-owned ones, accounting for 52% of China's GDP but just 27% of bank credit.

Wholesale Effort
China's policymakers must end this implicit guarantee and make all companies compete for funding on an equal footing. This would pressure SOEs to raise their productivity to continue to attract capital—which, in turn, would spur productivity in the economy as a whole. The McKinsey Global Institute calculates that improving the allocation of capital in China and improving the efficiency of the financial system could boost GDP by up to 17% annually—or well north of $300 billion.

Complete deregulation of interest rates—both for deposits and loans—is fundamental. China is planning to do this gradually, but the process isn't due to be completed until 2010. Without faster deregulation, China's banks will continue offering artificially cheap loans, which distorts the economy and stifles competition. The banks will maintain high margins, but will have little incentive to improve. China's prodigious savers will continue to pay the price in the form of meager returns on their savings.

Inefficient capital allocation isn't solely a concern for the banking sector. The performance of banks, equity markets, bond markets, and payment systems are all interdependent—so each of these needs to be reformed at the same time. A corporate bond market, for instance, could provide competition for banks and is the usual alternative for big companies in most countries. But China's is tiny: The value of corporate bonds outstanding in the mainland amounts to only 1% of GDP, compared with 68% in South Korea and 74% in Malaysia. China's bond market won't grow and compete with banks, however, without reforms to make it more amenable both to large issuers and institutional investors.

Prolonged Growth
To foster competition throughout the financial system, regulators should allow private domestic investors into the financial sector, and raise limits on foreign ownership for banks. Like the large banks now slated for IPOs, smaller city banks will also need new skills and technology to thrive in a more competitive lending market. More of them should be privatized altogether. Regulators should also require higher standards of governance at all banks. It would be useful to broaden the definition of collateral to include assets beyond a borrower's property, since land titles are unclear in many parts of China. This would enable more small and mid-size private businesses to obtain credit.

The transformation of China's economy over the past 25 years has produced astonishing growth and prosperity for the Chinese people. The country now needs a market-oriented financial system that will promote more balanced, sustainable growth.

Diana Farrell is the director of the McKinsey Global Institute, McKinsey's economics think tank.

This article originally ran in Businessweek.

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